Investors who steer clear of traditional "sin" stocks like alcohol, tobacco and firearms manufacturers may be keeping their conscience clean at the cost of more lucrative returns.

While companies in vice industries are sensitive to lawsuits and the whims of regulators, some academic research and proponents of vice investing suggest these stocks may be undervalued by the markets due to a negative stigma that causes some institutional investors and Wall Street analysts alike to bypass them.

According to S&P Capital IQ, four of the five S&P 1500 sub-industries that fit in this sin category sport higher five-year compound annual growth rates than the broader market.

“There are plenty of people who would rather (give) away their money by putting it into wind mills,” said Gerry Sullivan, who manages the $125 million Vice Fund. “We offer a specific type of investment that has done extraordinarily well.”

The Vice Fund (VICEX), which primarily invests in the tobacco, alcohol, gaming and defense industries, rallied 21.16% in 2012, besting a 16% gain for the S&P 500.

A number of sin stocks have generated strong returns over the past 12 months, highlighted by brewing giant Anheuser-Busch InBev (BUD) and Penn National Gaming (PENN).

FULL COVERAGE: From tobacco and booze to porn and gambling, what’s the best way to capitalize on "sin"? Find it all here at our special coverage of the Business of Vice.

Why Have Sin Stocks Outperformed?

Since the Vice Fund, which has a 5-star rating from Morningstar, was founded in 2002, it has outstripped the broader market 9.36% to 6.5%.

“We’ve taken a methodology and stuck to it through very difficult periods,” said Sullivan. “There seems to definitely be a discount in these types of stocks. It may come because they’re not as broadly held.”

Sullivan points to academic research that concludes sin stocks outperform due to a number of factors, including monopolistic pricing and the fact that many large institutional investors can’t or won’t invest in them.

Sin stocks “have higher expected returns than otherwise comparable stocks, consistent with them being neglected by norm-constrained investors and facing greater litigation risk heightened by social norms,” Harrison Hong of Princeton University and Marcin Kacperczyk of NYU, wrote in a 2009 paper published in the Journal of Financial Economics.

Drilling into the S&P 1500, Capital IQ data reveal that the distillers/vintners and tobacco subsectors have generated five-year compound annual growth rates (CAGRs) of 14.6% and 11.4%, respectively, trouncing the S&P 1500’s 3.8% gain. Brewers also beat the broader market by that measure, logging a 5-year CAGR of 10.8%.

This outperformance trend continues when ancillary groups like soft-drink makers and hotel/resorts/cruise lines are included in the equation.

Only the casinos/gaming subsector, which was slammed by the Great Recession, lags behind the market by suffering a -6.4% CAGR over the past five years.

Obstacles Remain

Despite this recent history of beating the broader markets, it’s clear that some groups of sin stocks face serious headwinds.

For example, firearms makers like Smith & Wesson (SWHC) have been hit by uncertainty following calls for stronger gun laws after the December massacre in Newtown, Conn., that left 28 dead, most them children.

Shares of Smith & Wesson and Sturm, Ruger & Co. (RGR) tumbled in the wake of the mass shooting, but have since recovered their lost ground.

Sullivan said Vice Funds acquired a stake in Smith & Wesson after the Sandy Hook shooting when it fell to $8 -- a 16% discount to its close at $9.52 on Wednesday.  

“I’m not that worried that sales are going to be impacted,” Sullivan said, adding that ultimately the push for greater regulation will be a “nonevent to a positive” for stock prices.

Tobacco companies like Altria (MO) continue to grapple with heavy taxes and a secular decline in the popularity of smoking due largely to health concerns. According to a July 2012 Gallup poll, just 20% of respondents said they had smoked a cigarette in the past week, down from 28% in 2001.

Sullivan pointed to elasticity in cigarette prices that help overcome sales slumps as well as the advent of e-cigarettes.

While the tobacco business “over a very long period of time will continue to decline…today’s valuations probably still allow for potential returns even facing such Draconian macro industry odds,” said Thomas Russo, who manages over $6 billion at Gardner Russo & Gardner, which owns shares of Altria and Philip Morris International (PM).  

At the opposite end of the regulation spectrum, gaming stocks have been influenced by the increased willingness of states like New Jersey to legalize certain forms of online gambling. The Borgata, the luxury Atlantic City resort owned by Boyd Gaming (BYD) and MGM Resorts (MGM), recently became the first U.S. casino to offer in-room electronic gambling services.

Investing With a Conscience

While some funds cater to investors who seek to capitalize on sin stocks, socially-responsible funds take a decidedly different approach.

Mutual fund Calvert Investments, which has $12.3 billion in assets under management, is one of the leaders in this socially-responsible arena.

“People like to invest to some extent in alignment with their values -- whether it’s political views, cultural attitudes or religious beliefs,” said Bennett Freeman, senior vice president of sustainability research and policy at Calvert Investments.

Calvert's largest socially-responsible fund, the Calvert Equity Portfolio (CSIEX), has $2.6 billion in assets under management. This fund gained 11.42% over the past 12 months, compared with a 13.4% rally for the S&P 500 and a 16.53% rally for the Vice Fund. 

Freeman said Calvert’s 23 social funds won’t invest in alcohol, gambling or tobacco stocks. While the fund has become less restrictive of defense companies, it still won’t invest in companies that produce weapons that either violate international humanitarian law or are inherently offensive.

He said that means Calvert can invest in engine maker General Electric (GE), but not United Technologies (UTX), which manufactures the formidable BlackHawk helicopter.

The approach of vice stock funds is “180 degrees opposite from ours. It represents different cultural or moral attitudes,” said Freeman. “They think they have an investment proposition behind their approach that leads to greater value in some ways. We believe that we do too.”

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